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:: Partnership - Audit Technique Guide - Overview (12-2002)
Overview -
Table of Contents
PROLOGUE
This Market
Segment Specialization
Program (MSSP) Guide is
designed to assist examiners
in classifying and examining
partnership returns. The
focus is on issues that fall
within sections 701 through
761 of the Code (Subchapter
K). Subchapter K deals
primarily with the
formation, operation, and
termination of
partnerships. Many issues
arise during the initial or
final year of the
partnership.
If your
return relates to an
operating business (as
opposed to rentals), you
should also look for an MSSP
Guide for that type of
business.
The Tax Equity and Fiscal
Responsibility Act of 1982
created the “TEFRA Entity.”
Returns qualifying as TEFRA
Partnerships and their
partners are subject to
these “unified procedures”
which are contained in IRC
sections 6221 6234. The
procedures are briefly
explained in Chapter 13.
DEFINITION AND FORMATION
IRC section
761(a) defines a partnership
as any organization through
or by means of which any
business, financial
operation, or venture is
carried on which is not a
corporation, trust or
estate.
A
partnership is formed when
two or more “persons” agree
to carry on a joint
venture. A written
agreement, although
preferred, is not required.
State law now generally
requires that a partnership
have a written agreement.
Partnership agreements
should cover initial capital
contributions, required
services, life of the
partnership and other
important items. Such
agreements must always be
inspected when examining a
partnership return.
Pre-opening
expenses must be capitalized
just as with any other
business. In addition,
certain expenses of
organizing the partnership
must also be capitalized
(see Initial Year Return
Issues, Chapter 1).
Where a
partnership is engaged in an
investment activity (not a
trade or business), or where
used for the joint
extraction, production or
use of property, a
partnership can elect out of
the provisions of Subchapter
K. For example, if two
brothers own a parcel of
land and farm it, it is a
partnership; if they each
take their share of the
crop, and expenses, they can
elect out of Subchapter K.
PARTNERSHIP ENTITIES
Partnerships, like
corporations, are creatures
of the State, whose laws
provide for their creation,
operation and liquidation.
Initially, all partnerships
were “General Partnerships”
where each and every partner
was jointly and severally
liable for all partnership
debts. For example, Lloyds
of London is a group of
syndicates engaged in the
insurance business.
Recently, many of the
investors were surprised to
discover that they were
general partners subject to
liabilities from claims of
environmental damages and
the like.
Because of
the dangers of unlimited
liability, it became
difficult to find investors
for joint ventures. This
resulted in the creation of
Limited Partnerships under
state statutes where a class
of partners who were not
active in the business but
were merely investors, could
receive limited liability
for partnership debts and
actions. Under these
Uniform Partnership laws,
professionals could not be
limited partners since they
were “active” in the
business. This meant that
partners engaged in law,
medicine, or accounting
could not have limited
liability and each partner
was jointly and severally
liable for the errors,
omissions, and malpractice
of any partner. As a result
of pressure from these
groups, states enacted
statutes to provide for
Limited Liability Company’s
(LLC’s) and Limited
Liability Partnerships
(LLP’s). Using these
entities, professional
partners can now use a
partnership form and not be
liable for the “sins” of
other partners; they would
still be completely liable
for their own malpractice.
As a result of these state
law changes, the Service
issued regulations providing
that these entities would be
taxed as partnerships unless
they elected to be taxed as
a corporation by checking a
box on Form 8832 and
attaching it to their
initial return (the
“Check-the-Box
Regulations”). These
entities are partnerships
for tax purposes, but see
Self-Employment Tax in
Chapter 12.
Note that a
single member LLC is
generally a sole
proprietorship if the member
is an individual. In the
case of a corporation or
partnership owning a single
member LLC, the LLC is
considered a “Division” and
is not required to file a
return if the income and
expenses are reported on the
return of the member.
OPERATIONS
During the
operating years of a
partnership, the tax issues
are generally the same as a
corporation or sole
proprietorship. The amount
of income determined at the
partnership level and
allocated to the partners
according to the partnership
agreement must be reported
whether or not there are any
cash distributions. Income
allocated disproportionately
among the partners may be
adjusted on examination if
the allocation was done
solely for tax purposes and
does not reflect economic
reality. Partnership losses
are passed through to
partners, whether general or
limited partners, and are
allowed to the extent of the
partner’s basis in their
partnership interest. It is
important to remember that a
partner’s share of
liabilities is included in
the calculation of their
basis in their partnership
interest. When inspecting a
partner’s Schedule K-1, it
may be disconcerting to see
that the partner has a
negative capital account;
that is, the partner has
deducted losses in excess of
their cash investment. This
occurs because the capital
account does not include the
partner’s share of
liabilities. If the amount
of liabilities allocated to
the partner (shown on
Schedule K-1 just above the
ending capital account) is
not greater than the capital
account, the partner’s
losses should be limited.
In addition to basis
limitations, partnership
losses are subject to
limitations for “at-risk”
basis and passive losses.
See Loss Limitations.
LIQUIDATION/TERMINATION
Care must
be taken to ensure that any
negative capital account is
reported in income in the
year of liquidation.
Although partners are happy
to include liabilities in
basis during the operating
years in order to deduct
losses, they frequently
forget to include those
liabilities in the amount
realized on the disposition
of their interest. Since
the partner is “deemed” to
be relieved of liabilities
on the disposition of his
partnership interest, even a
gift or charitable
contribution of a
partnership interest will
result in a gain where the
capital account was
negative. Sometimes the
final partnership return
will show that some partners
have negative capital
accounts and others are
positive- the total of the
ending capital accounts
being zero. The regulations
require that final year
income be allocated to those
with negative capital
accounts until they reach
zero such that all ending
capital accounts are zero.
ENTITY
VERSUS AGGREGATE
There is a
basic tension between the
“Entity” and “Aggregate”
Theories of partnership
accounting for tax
purposes. Under the Entity
Theory, the amount and
character of partnership
income is determined at the
partnership level as though
it was an entity separate
from its partners. This
includes elections such as
accounting method and other
initial year elections.
According to the Aggregate
Theory, each partner is
treated as the owner of a
direct and undivided
interest in partnership
assets, liabilities and
operations. Tax is actually
paid at the partner level.
For tax rules that provide
separate elections or
limitations, such as IRC
section 108 cancellation of
debt (COD) income
exclusions, itemized
deductions, and tax
preferences, partners are
treated as a group of
individual sole
proprietorships.
The Service
and the Courts have
struggled at times to try to
determine which concept
should apply in different
circumstances. Many tax
shelters, including Abusive
Corporate Tax Shelters rely
on the Entity Theory to
determine the character or
allocation of income; they
use (or abuse) subchapter K
to achieve a result that
could not occur without a
partnership cloak. If you
believe the partnership you
are examining is a tax
shelter carefully review the
Tax Shelter chapter.
Another
example of these separate
approaches is IRC section
179, depreciation; Congress
specified that the $17,500
limitation would apply at
the partnership level
(Entity) and that the
partner would also be
subject separately to the
limitation (Aggregate).
That is, the partner’s share
from the partnership would
be added to any IRC section
179 depreciation the partner
had from other businesses in
computing the limitation,
even though it had already
been limited at the
partnership level.
With
increased filings of
partnership returns, this
area of tax law has taken on
increased importance.
Although this guide is not
all-inclusive, we hope that
it will serve the needs of
the examiners in the field.
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